The financial accounting and reporting (FAR) test covers topics related to accounting transactions and generating financial statements. This test is the number-crunching section of the CPA exam. The FAR test includes pensions, which I think is one of the most difficult concepts to grasp on the exam. Use these tips to get a handle on accounting on pensions.
Type of pensions
A pension is a series of income payments to an employee when that worker retires. Companies offer pensions as an employee benefit. However, the type of pension a company offers has a huge impact on the firm’s liability for the payments.
Until the last 20 years or so, most pensions were defined benefit plans. Under a defined benefit plan, the employer is obligated to pay a specific amount of payments to the former employee in retirement. Those payments are based on several factors, including years of service and the worker’s final salary level. In some cases, the requirements of a defined benefit plan are determined by a union contract.
In recent years, many companies have stopped funding defined benefit plans and shifted to defined contribution plans. If you’re working, your company probably offers this type of plan. Under this pension agreement, the company is obligated to contribute a certain dollar amount into the fund for each worker. For example, the business may pay 2% of the worker’s gross pay into the pension plan. The employer’s liability is on the contribution amount- not on the ultimate amount of pension income paid to the employee.
It’s critically important that you understand these differences, so that you can tackle test questions with confidence.
What’s in the bucket?
Think about the pension plan as a bucket and consider how money is added to and subtracted from that bucket. The employer increases money in the bucket by making plan contributions. In addition, those contributions earn an expected rate of return. That rate is an assumption about investment earnings in the portfolio. So, imagine plan contributions and a planned rate of return pouring into the bucket.
When an employee retires, money starts flowing out of the bucket. The dollars flowing out are based on several types of costs incurred by the employer. The service cost represents the number of years of service and the salary level that determines the pension payment (in a defined benefit plan). There’s also an assumption that the worker will earn interest on any pension payments they are owed. That interest is also a cost to the employer.
The accounting entry
All of these factors drive an accounting entry on the company’s books. The employee’s pension liability is called the projected benefit obligation (PBO). The amount is compared with the current value of the plan assets. If the plan assets are higher than the PBO, the company has a net pension asset- there is more money in the bucket than needed to pay pensions. If plan assets are less than the PBO, the company has a net pension liability.
The language on the pensions section of the FAR test can be really difficult. Use these tips to understand the accounting entries for pensions.